Firms in competitve market(Microeconomics)

CHAPTER

11|Firms in Perfectly Competitive Markets

Chapter Summary and Learning Objectives 11.1 Perfectly Competitive Markets (pages 369–371) Explain what a perfectly competitive market is and why a perfect competitor competitor faces a horizontal demand curve. A perfectly competitive market must have many buyers and sellers, firms must be producing identical products, and there must be no barriers to entry of new firms. The demand curve for a good or service produced in a perfectly competitive market is downward sloping, but the demand curve for the output of one firm in a perfectly competitive market is a horizontal line at the market price. Firms in perfectly competitive markets are price takers and see their sales drop to zero if they attempt to charge more than the market price. 11.2 How a Firm Maximizes Profit in a Perfectly Competitive Market (pages 371–374) Explain how a firm maximizes profit in a perfectly competitive market. Profit is the difference between total revenue ( TR) and total cost ( TC ). ). Average revenue ( AR) AR) is total revenue divided by the quantity of the product sold. A firm maximizes profit by producing the level of output where the difference between revenue and cost is the greatest. This is the same level of output where marginal revenue is equal to marginal cost. Marginal revenue ( MR) MR) is the change in total revenue from selling one more unit. 11.3 Illustrating Profit or Loss on the Cost Curve Graph (pages 374–379) Use graphs to show a firm’s profit or loss. From the definitions of profit and average total cost, we can develop the following expression for the relationship between total profit and average total cost: Profit = ( P P − ATC ) × Q. Using this expression, we can determine the area showing profit or loss on a cost-curve graph: The area of profit or loss is a box with a height equal to price minus average total cost (for profit) or average total cost minus price (for loss) and a base equal to the quantity of output. 11.4 Deciding Whether to Produce or to Shut Down Down in the Short Run (pages 379–382) Explain why firms may shut down temporarily. In deciding whether to shut down or produce during a given period, a firm should ignore its sunk costs. A sunk cost is a cost that has already been paid and that cannot by recovered. In the short run, a firm continues to produce as long as its price is at least equal to its average variable cost. A perfectly competitive firm’s shutdown point is the minimum point on the firm’s average variable cost curve. If price falls below average variable cost, the firm shuts down in the short run. For prices above the shutdown point, a perfectly competitive firm’s marginal cost curve is also its supply curve. 11.5

“If Everyone Everyone Can Do It, You Can’t Make Money Money at It”: The Entry and Exit of Firms in the Long Run (pages 382–388) Explain how entry and exit ensure that perfectly competitive firms earn zero economic profit in the long run. Economic profit is a firm’s revenues minus all its costs, implicit and explicit. Economic loss is the situation in which a firm’s total revenue is less than its total cost, including all implicit costs. If firms make economic profits in the short run, new firms enter the industry until the market price has fallen enough to wipe out the profits. If firms make economic losses, firms exit the industry until the market price has risen enough to wipe out the losses. Long-run competitive equilibrium is the situation in which the entry and exit of firms has resulted in the typical firm breaking even. The long-run supply curve shows the relationship between market price and the quantity supplied.

©2010 Pearson Education, Inc. Publishing as Prentice Hall

282

CHAPTER 11 | Firms in Perfectly Competitive Markets

11.6 Perfect Competition and Efficiency (pages 389–391) Explain how perfect competition leads to economic efficiency. Perfect competition results in productive efficiency, which means that goods and services are produced at the lowest possible cost. Perfect competition also results in allocative efficiency, which means the goods and services are produced up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it.

Chapter Review Chapter Opener: Perfect Competition in the Market for Organic Apples (page 367) The market for organic apples has grown rapidly. In response to rising demand and high profits, many apple growers switched to organic methods. The entry of new firms rapidly increased supply, which decreased the price and profit associated with the production of organic apples. Today, the industry has the characteristics of a perfectly competitive market. Each apple producer has only a small share of the overall market; therefore each firm is a price taker.

11.1

Perfectly Competitive Markets (pages 369–371) Learning Objective: Explain what a perfectly competitive market is and why a perfect competitor faces a horizontal demand curve.

A perfectly competitive market is a market that meets the conditions of (1) many buyers and sellers, (2) all firms selling identical products, and (3) no barriers to new firms entering the market. Prices in perfectly competitive markets are determined by the intersection of market demand and supply. Consumers and firms must accept the market price if they want to buy and sell in a competitive market. A price taker is a buyer or seller that is unable to affect the market price. A firm in a perfectly competitive market is a price taker because it is very small relative to the market and sells exactly the same product as every other firm. Consumers are also price takers. Although the market demand curve has the normal downward shape, the demand curve for a perfectly competitive firm is horizontal at the market price because the firm is unable to affect the market price.

 Study

Hint

Spend some time reviewing Table 11-1 on page 368 because it provides an overview of the four market structures. This chapter focuses on perfect competition. You will see the other three market structures in the upcoming chapters. Differences across the three characteristics of the number of firms, the type of product, and the ease of entry are the key to to defining which structure structure applies to a given market. market.

Extra Solved Problem 11-1 Supports Learning Objective 11.1: Explain what a perfectly competitive market is and why a perfect competitor faces a horizontal demand curve. You and your sister have decided to start a petsitting business. business. You ask around your neighborhood and find that petsitting generally pays $20 per day. If the market for petsitting is perfectly competitive, what price will you charge for your petsitting petsitting services? What does this imply imply about the demand curve facing your new business?



283

SOLVING THE PROBLEM Step 1:

Step 2:

11.2

Review the chapter material. This problem is about the definition of a perfectly competitive market and the effect of market structure on the firm’s ability to control price, so you may want to review the section “Perfectly Competitive Markets,” which begins on page 369 in the textbook. Determine the price a perfectly competitive firm charges for its product or service. Firms in a perfectly competitive industry do not have the ability to affect the price. They are price takers who are unable to affect the market price no matter how much they produce. If you charge any more than the market equilibrium price $20 per day for petsitting, then customers will simply simply turn to alternative alternative suppliers. Because an individual firm is such a small fraction of the market supply, no individual supplier can charge a price that is any different from the market price. Therefore, you will charge $20 per day for petsitting services. Because perfectly competitive firms are price takers, they face a demand curve that is horizontal at the market price. Therefore, you and your sister will face a demand curve curve that is horizontal at a market price of $20 per day in the petsitting market.

How a Firm Maximizes Profit in a Perfectly Competitive Market (pages 371–374) Learning Objective: Explain how a firm maximizes profit in a perfectly competitive market.

Economists assume that the objective of a firm is to maximize profits. Profit is the difference between total revenue (TR) and total cost ( TC ): ): Profit = TR – TC Therefore, a firm will produce that quantity of output where the difference between TR and TC is is as large as possible. A firm’s average revenue ( AR) AR) equals total revenue divided by the number of units sold. Average revenue is the same as market price. For a firm in a perfectly competitive market, price is also equal to marginal revenue. Marginal revenue ( MR) MR) is the change in total revenue caused by producing and selling one more unit: ΔTR Marginal Revenue = MR = ΔQ The marginal revenue curve for a perfectly competitive firm is the same as its demand curve. The marginal cost ( MC ) of production for a perfectly competitive firm first falls, then rises. So long as MR exceeds MC , the firm’s profits are increasing and production will increase. The firm’s profits will decrease if production is increased beyond the output for which MC exceeds exceeds MR. The profit maximizing level of output is where MR = MC . Because P = = MR for these firms, profit will be maximized when P = = MC .


284


 Study

Hint

You might be wondering, “Why would a seller produce a unit of output for which MR = MC , as it would not earn any profit from this last unit?” If MR = MC , then the firm is earning just enough revenue to cover the cost of producing the last unit of output. If the firm chose not to produce this unit of output, then it would stop produci producing ng at a point point where where MR > MC . The firm maximizes profit by continuing to expand production just to the point where MR = MC .

Extra Solved Problem 11-2 Cost and Revenue for Apples R’ Us Supports Learning Objective 11.2: Explain how a firm maximizes profit in a perfectly competitive market. Sally Borts owns Apples R’ Us, an orchard located in Washington State. Sally is one of about 7,500 apple producers in the United States who produced over 14 billion pounds of apples in 2008. That year, the average price of apples was 23 cents per pound (or (or $230 per 1,000 pounds). Sally’s revenue and costs of production for various quantities quantities of apples are shown shown in the table below. below. Output (000 lbs.) 0 1 2 3 4 5 6 7 8

Total cost (000) $50 150 235 330 430 550 720 950 1,270

Marginal cost (000) ----$100 85 95 100 120 170 230 320

Total revenue (000) $0 230 460 690 920 1,150 1,380 1,610 1,840

Marginal revenue (price per 1,000 lbs) ----$230 230 230 230 230 230 230 230

Source: http://usapple.org/media/newsreleases/inr082109.pdf

a.

Determine whether Apples R’ Us is a perfectly competitive firm.

b. Explain how Sally will decide how much to produce.


Step 2:

Review the chapter material. This problem is about how a firm maximizes profit, so you may want to review the section “How a Firm Maximizes Profit in a Perfectly Competitive Market,” which begins on page 371 in the textbook. Determine if Apples R’ Us is a perfectly competitive firm. Sally is one of thousands of apple producers, and her output is a small fraction of the total number of apples produced. Within each variety of apples (Red Delicious, McIntosh, Granny Smith, etc.) apple growers sell an identical product and new firms are free to enter the market. Therefore, Apples R’ Us is a perfectly competitive firm. In addition, marginal revenue is constant, which means that price must also be constant, and the demand curve facing Apples R’ Us must be horizontal. Price and marginal revenue are constant and the demand curve is horizontal only in a perfectly competitive market.



Step 3:

11.3

285

Explain how Sally will decide how much to produce. Sally should increase her production of apples so long as the marginal revenue exceeds her marginal cost of production. The profit-maximizing level of output is where marginal revenue equals marginal cost. Sally’s marginal revenue equals the $230 price of a thousand pounds of apples. Therefore, Sally should produce up to 7 thousand pounds of apples. At 7 thousand pounds, her marginal cost is equal to the marginal revenue of $230, and she is maximizing her profit.

Illustrating Profit or Loss on the Cost Curve Graph (pages 374–379) Learning Objective: Use graphs to show a firm’s profit or loss.

Profit equals total revenue ( TR) minus total cost ( TC ). ). Because TR equals price multiplied by quantity sold, this can be written as: Profit = ( P × × Q) – TC Dividing both sides by Q: Profit Q

=

( P × Q ) Q

−

TC Q

Or:

Profit = P − ATC Q This equation means that profit per unit (or average profit) equals price minus average total cost. Multiplying both sides of the equation by Q yields an equation that tells us a firm’s total profit is equal to the quantity produced multiplied by the difference between price and average total cost. ( P – ATC is called the profit margin per unit.) Profit = ( P – ATC ) × Q Figure 11-4 on page 375 in the textbook textbook illustrates the situation situation where the firm is making a profit. Figure 11-5 on page 378 illustrates the situations where the firm is either breaking even or suffering a loss. The firm will make a profit if P > > ATC . The firm will break even if P = ATC . The firm will experience experience losses if P < ATC .

 Study

Hint

Solved Problem 11-3 provides an example of an individual firm in a perfectly competitive market. Study this Solved Problem carefully and be sure you understand the graphs that show a firm’s profit or loss. If properly drawn, graphs can help you to answer questions that would be more difficult to answer using only words or numbers. Here are tips to learning from these graphs: (1) When a firm’s demand curve intersects the ATC curve, price will exceed ATC for some level of output. That means the firm earns a profit. (2) To show a firm suffering losses, the ATC curve curve is drawn everywhere above the demand curve, which would mean that the price is less than the average total cost. (3) Always draw the demand curve and the MC curve first to determine the profit-maximizing output. This will make it easier to identify ATC and AVC at at this same output.


286

11.4


Deciding Whether to Produce or to Shut Down in the Short Run (pages 379–382) Learning Objective: Explain why firms may shut down temporarily.

In the short run, a firm suffering losses has two options: produce or shut down. The firm will produce the profit-maximizing output if its total revenue is greater than its total variable cost. In this situation, even though the firm is suffering a loss, it is earning enough revenue to cover all of its variable costs and at least some of its fixed costs. The firm’s second option is to stop production by shutting down temporarily (producing zero output). During a temporary shutdown, a firm must still pay its fixed costs. If, by producing, the firm would lose an amount greater than its fixed costs (that is, the firm will not be able to cover all of its variable costs), then it will shut down. A sunk cost is a cost that has already already been paid and cannot be recovered. The firm should treat its sunk costs as irrelevant to its decision making. The firm’s marginal cost curve is its supply curve only for prices at or above average variable cost. The shutdown point is the minimum point on a firm’s average variable cost curve. If the price falls below this point, the firm shuts down production production in the short run. The market supply curve can be derived by adding up the quantity quantity that each firm in the the market is willing to to supply at each price. For a given price, the quantity each firm in the market is willing to supply can be determined from the marginal cost curve, so a firm’s supply curve is the portion portion of the marginal cost curve that lies lies above average variable cost.

 Study

Hint

The decision to shut down is not the same as deciding to leave the market or go out of business. Many firms sell goods or services only in certain seasons. Examples include ski resorts, retail stores near summer resorts, and Christmas tree vendors. These firms shut down temporarily during the off season. Going out of business permanen permanently tly,, however, however, is a long-ru long-run n decision. decision. See Making the Connection “When to Close a Laundry” for an example of a firm that is not making a profit. The laundry had $3,300 per month in fixed costs and was losing $4,000 per month while operating. If the laundry closed down it would only lose $3,300 per month instead of $4,000, so the firm should shut down. The owner of the laundry brought in a new manager who reorganized the business so that it was now losing only $2,000 per month. Under this reorganization, the firm should stay in business because it is losing only $2,000 per month while operating compared to the $3,300 per month that would be lost if it shut down.

Extra Solved Problem 11-4 Apples R’ Us–Continued Supports Learning Objective 11.4: Explain why firms may shut down temporarily. The table that follows follows represents costs costs for the perfectly competitive competitive firm Apples R’ Us. As in Extra Solved Problem 11-2, the market equilibrium price in this competitive market is $230 per thousand pounds of apples produced. produced.



a.

Output (000 lbs.)

Total cost (000)

Marginal cost (000)

0 1 2 3 4 5 6 7 8

$50 150 235 330 430 550 720 950 1,270

----$100 85 95 100 120 170 230 320

287

Average variable cost (000)

Determine the rule that Apples R’ Us will use to determine whether it will produce at various market prices.

b. Complete the “Average variable cost” column. Should the firm produce and sell apples if the the price is $100 per 1,000 pounds of apples instead of $230 per 1,000 pounds, or should the firm shut down? What about a price of $85 per 1,000 pounds of apples?


Step 2:

Step 3:

Review the chapter material. This problem is about whether a firm should continue to produce or shut down at various possible market prices, so you may want to review the section “Deciding Whether to Produce or to Shut Down in the Short Run,” which begins on page 379 in the textbook. Determine the rule that Apples R’ Us will use to determine whether they should produce at each price mentioned in the problem. Apples R’ Us will compare the market price to the minimum value of average variable cost. If the price is greater than the minimum AVC , then the firm will produce where MR = MC . If the price is below the minimum AVC , then the firm will shut down in the short run. Apples R’ Us should continue to produce in the short run as long as the price is greater than $93.33, which is the minimum value for AVC . If the price falls below $93.33, then the firm will shut down because its loss will be greater than its fixed cost. Calculate AVC for the firm, and compare each price to the rule from Step 2 to determine whether the firm will produce or shut down at each given price. Output (000 lbs.)

Total cost (000)

Marginal cost (000)

0 1 2 3 4 5 6 7 8

$50 150 235 330 430 550 720 950 1,270

----$100 85 95 100 120 170 230 320

Average variable cost (000) ---$100 92.50 93.33 95 100 111.67 128.57 152.50


288


The total cost of $50 that is paid even when output is zero represents the fixed costs of production. Because fixed costs do not change as output changes, this $50 fixed cost is part of cost for every level of output. Any costs greater than the $50 fixed cost cost must be variable costs then, and AVC is is calculated as variable cost divided by output, as shown in the table above. Apples R’ Us will continue to produce in the short run when the price is $100 per thousand pounds of apples. The firm will choose to produce all levels of output where marginal revenue of $100 is at least as great as the marginal cost, and will maximize profit where marginal revenue equals equals marginal cost. Marginal revenue is equal to marginal marginal cost at 4 thousand pounds of apples, so profit will be maximized when the firm produces 4 thousand pounds of apples. In this case, profit is negative $30, but the loss of $30 is a higher level of profit than the loss of $50 $50 the firm would suffer if it shut down. down. When the price falls to $85 per thousand pounds, the firm will shut down because the price has fallen below the minimum of AVC . In this case, the firm cannot collect enough revenue to cover its variable costs, so there is no no money left over to pay down the fixed fixed costs. Even though the $85 price is equal to the marginal cost of producing 2 thousand apples, producing 2 thousand apples would generate a loss for the firm of $65. $65. If the firm chooses simply simply to shut down when the price is $85, then it will suffer a loss of only $50.

11.5

“If Everyone Can Do It, You Can’t Can’t Make Money at It”: The Entry and Exit of Firms in the Long Run (pages 382–388) Learning Objective: Explain how entry and exit ensure that perfectly competitive firms earn zero economic profit in the long run.

In the long run, unless a firm can cover all of its costs it will shut down and exit the industry. Economic profit is a firm’s revenues minus all its costs, implicit and explicit. An economic loss means a firm’s total revenue is less than its total cost, including all implicit costs. If firms in a perfectly competitive market are earning economic profits in the short run, then new firms will have an incentive to enter the market so they, too, can earn an economic profit. The entry of new firms shifts the industry supply curve to the right. As a result, the market price will fall. The entry of firms will continue until price is equal to average total cost. If firms in a perfectly competitive market are suffering losses in the short run, some of these firms will exit the industry because they will not be able to cover all of their costs. The exit of firms shifts the industry supply curve to the left. As a result, the market price will rise. The exit of firms will continue until price is equal to average total cost. Long-run competitive equilibrium is the situation in which the entry and exit of firms have resulted in the typical firm breaking even. The long-run supply curve shows the relationship in the long run between market price and the quantity supplied. A constant cost industry is an industry in which the typical firm’s long-run average costs do not change as the industry expands. This means that the firm will have a horizontal long-run supply curve. An increasing cost industry is an industry in which the typical firm’s long-run average costs increase as the industry expands. expands. This means the firm will have an upwardsloping long-run supply curve. A decreasing cost industry is an industry in which the typical firm’s longrun average costs decrease as the industry expands. expands. This means that the the firm will have a downward downward sloping long-run supply curve.



 Study

289

Hint

Which firms are most likely to leave an industry industry that is experiencing economic economic losses? Even though we assume all firms are identical, that is not true in the real world. Some firms have more financial resources and are better able to withstand withstand short periods periods of negative profits. profits. Financially weaker firms are more more likely to exit. For example, a corporate-owned Starbucks is more likely to sustain economic losses due to slow sales and remain in the industry than is a local coffee shop.

Extra Solved Problem 11-5 Apples R’ Us–Continued Supports Learning Objective 11.5: Explain how entry and exit ensure that perfectly competitive firms earn zero economic profit in the long run. Consider the perfectly competitive market in which Apples R’ Us competes. Suppose that the price is $100 per thousand pounds of apples and that all firms face the same costs as those shown for Apples R’ Us below.

a.

Output (000 lbs.)

Total cost (000)

Marginal cost (000)

0 1 2 3 4 5 6 7 8

$50 150 235 330 430 550 720 950 1,270

----$100 85 95 100 120 170 230 320

Average variable cost (000) ---$100 92.50 93.33 95 100 111.67 128.57 152.50

What will happen to the supply in this industry in the long run? What is the effect of this change in supply on price?

b. What will happen to the long-run profit of firms that remain in the market for apples?


Step 2:

Review the chapter material. This problem is about long-run losses, so you may want to review the section “‘If Everyone Can Do It, You Can’t Make Money at It’: The Entry and Exit of Firms in the Long Run,” which begins on page 382 in the textbook. Answer part (a) by determining what short-run profit looks like for a typical firm in the industry and discuss the incentive effect that this profit has on the firm. If each firm has the same costs as Apples R’ Us, each firm in the industry will be suffering a loss of $30 at the the price of $100 per thousand thousand pound of apples. These losses give firms firms an incentive to exit the industry in the long run because the owners of the firms could receive a greater return on their investment somewhere else.


290


Step 3:

11.6

Answer part (b) by determining how this incentive will alter the market supply curve and the profit of remaining firms. Because profits are negative, some firms will exit the apple market, which will cause the market supply curve to shift to the left. A decrease in supply will cause the market price for apples to rise. ris e. As firms exit the the industry, the price will will continue to rise up to the the point where all remaining firms in the industry will be earning zero economic profit. The firms who remain are making the same return producing apples as could be achieved in their next best alternative, so there is no additional incentive for firms to exit the market.

Perfect Competition and Efficiency (pages 389–391) Learning Objective: Explain how perfect competition leads to economic efficiency.

Productive efficiency is the situation in which a good or service is produced at the lowest possible cost. Perfect competition results in productive efficiency because the forces of competition drive the market price to the minimum average cost of the typical firm. Managers of firms strive to earn economic profits by reducing costs. But in a perfectly competitive market, other firms can quickly copy ways of reducing costs, so that in the long run consumers, not producers, benefit from cost reductions. Allocative efficiency is a state of the economy in which production represents consumer preferences. In particular, every good or service is produced up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it. Entrepreneurs in a perfectly competitive market efficiently allocate resources to best satisfy consumer wants.

 Study

Hint

Critics of the perfectly competitive model complain that few industries feature sellers of identical products who are all price takers. These critics fail to understand either what an economic model is or how economists use these models. Although not many markets are perfectly competitive, many markets are very competitive and experience entry and exit in response to short-run profits and losses. The markets for televisions, calculators, personal computers, and even automobiles have changed over time as firms earned short-run profits or new technologies forced firms to adapt. The steel and coal industries experienced exit by firms in response to short-run losses, just as the model of perfect competition predicts. The model also provides policymakers and analysts with a standard against which to judge the efficiency of real markets. When the price of a product is greater greater or less than marginal cost, one can argue that too little or too much of the product has been produced, a deviation from allocative efficiency.

Key Terms Allocative efficiency A state of the economy in which production represents consumer preferences; in particular, every good good or service is produced up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it.

Economic loss The situation in which a firm’s total revenue is less than its total cost, including all implicit costs.

Average revenue ( AR) AR) Total revenue divided by the quantity of the product product sold.

Long-run competitive equilibrium The situation in which the entry and exit of firms has resulted in the typical firm breaking even.

Economic profit A firm’s revenues minus all its costs, implicit and explicit.



291

Long-run supply curve A curve that shows the relationship in the long run between market price and the quantity supplied. supplied.

Productive efficiency The situation in which a good or service is produced at the lowest possible cost.

Marginal revenue ( MR) MR) The change in total revenue from selling one more unit of a product.

Profit Total revenue minus total cost.

Perfectly competitive market A market that meets the conditions of (1) many buyers and sellers, (2) all firms selling identical products, and (3) no barriers to new firms entering the market.

Shutdown point The minimum point on a firm’s average variable cost curve; if the price falls below this point, the firm shuts down production in the short short run. Sunk cost A cost that has already been paid and that cannot be recovered.

Price taker A buyer or seller that is unable to affect the market price.

Self-Test (Answers are provided at the end of the Self-Test.)

Multiple-Choice Questions 1. Which of the following are characteristics of a perfectly competitive industry? a. firms are unable to control the prices of the products they sell b. firms are unable to earn an economic profit in the long run c. firms sell identical products d. all of the above 2. Which of the following conditions must exist in order to have a perfectly competitive market? a. There must be many buyers and many sellers, all of whom are small relative to the market. b. The products sold by firms in the market must be different from each other. c. There must be some barriers to entry in order to protect perfect competition. d. all of the above 3. A buyer or seller that is unable to affect the market price is called? a. a price maker b. a price taker c. an independent producer d. a monopoly


292


4. Refer to the graph below of the demand curve facing a firm in the perfectly competitive market for wheat. The fact that the demand curve is horizontal horizontal implies which which of the following?

a. The firm must lower the price of wheat to increase the quantity demanded. b. Increasing production of wheat from 3,000 bushels to 7,500 bushels results in an increase in marginal revenue. c. The market demand for wheat is identical to the demand for wheat faced by an individual firm. d. The firm can sell any amount of output as long as it accepts the market price of $4.00. 5. If an individual firm in a perfectly competitive market increases its price, the firm will experience a. higher revenue. b. lower average total cost. c. increased sales. d. none of the above 6. To maximize profit, which of the following should a firm attempt to do? a. maximize revenue b. minimize cost c. find the largest difference between total revenue and total cost d. all of the above



293

7. Refer to the graphs below. below. The graph on the left depicts depicts demand and supply supply in the competitive competitive market for wheat. The graph on the right depicts depicts the demand curve facing Farmer Whapple, Whapple, an individual producer in the market for wheat. The demand curve for Farmer Whapple’s wheat is horizontal at the market price of $4.00 because

a. b. c. d.

Farmer Whapple is the only supplier of wheat in this market. Farmer Whapple is a price taker. Farmer Whapple has control over the price of wheat. Farmer Whapple can choose whether he faces a downward sloping demand curve or a horizontal demand curve.

8. What is the relationship between price, average revenue, and marginal revenue for a firm in a perfectly competitive market? market? a. Price is equal to average revenue and greater than marginal revenue. b. Price is greater than average revenue and equal to marginal revenue. c. Price is equal to both average revenue and marginal revenue. d. Price, average revenue, and marginal revenue usually all have different values.


294


9. Refer to the table below. Based on the numbers in the table, how much should this farmer produce in order to maximize profit?

a. b. c. d.

QUANTITY (BUSHELS)

TOTAL REVENUE

TOTAL COSTS

MARGINAL REVENUE

MARGINAL COST

(Q)

(TR) TR)

(TC )

( MR) MR)

( MC MC )

4

16.00

9.50

4.00

2.00

5

20.00

12.00

4.00

2.50

6

24.00

15.00

4.00

3.00

7

28.00

19.50

4.00

4.50

8

32.00

25.50

4.00

6.00

9

36.00

32.50

4.00

7.00

10

40.00

40.50

4.00

8.00

10 bushels 9 bushels 6 bushels 4 bushels

10. Refer to the graph below. Based on the information on the graph, what is true about marginal revenue?

a. b. c. d.

marginal revenue increases as the quantity of bushels sold increases marginal revenue decreases as the quantity of bushels sold increases marginal revenue remains constant as the quantity of bushels sold increases marginal revenue is always greater than marginal cost



295

11. Refer to the graph below which shows the marginal cost and marginal revenue curves for a farmer in the perfectly competitive market for wheat. What is the profit-maximizing level of output if the producer can produce only whole whole units of output? output?

a. b. c. d.

3 bushels 10 bushels 6 bushels 8 bushels

12. Refer to the graph of costs for a perfectly competitive competitive firm below. below. Which of the following following best represents profit per unit?

a. b. c. d.

the shaded rectangle the distance between points A and B the market price none of the above


296


13. Refer to the graph below. Which of the curves in the graph is not necessary necessary for determining the level of output that maximizes profit for a perfectly competitive firm?

a. b. c. d.

the MC curve the demand curve the ATC curve All three curves are needed to determine which level of output maximizes profit.

14. Refer to the graph below. Which of the the curves is not necessary necessary for determining the level of profit earned by a perfectly competitive firm?

a. b. c. d.

the marginal cost curve the demand curve the average total cost curve All three curves are needed to determine the level of profit earned by a perfectly competitive firm.



297

15. Refer to the graph below. below. At what level of output does this perfectly competitive competitive firm maximize profit?

a. b. c. d.

Q1 Q2 Q3 0

16. Refer to the graph below. If a perfectly competitive competitive firm is producing producing at point A, which of the following is true?

a. b. c. d.

The firm earns zero accounting profit. The firm suffers a loss. The firm earns zero economic profit. The firm earns positive economic profit.


298


17. Refer to the graph below. What does the shaded area in the graph represent for a perfectly competitive firm that produces at output level Q?

a. b. c. d.

positive economic profit profit accounting profit negative economic profit total cost of producing Q

18. Refer to the graph below. At which of the following following prices is the perfectly perfectly competitive firm earning earning negative economic profit?

a. b. c. d.

$495 $250 both $250 and $495 any price above $495

19. What is the term given to a cost that has already been paid and cannot be recovered? a. unrecoverable cost b. variable cost c. sunk cost d. implicit cost



299

20. Refer to the graph below. Which demand curve is associated associated with the shutdown shutdown point point for this perfectly competitive firm? firm?

a. b. c. d.

Demand1 Demand2 Demand3 Demand4

21. Refer to the graph below. When the perfectly competitive firm faces demand curve Demand 3, which of the following is true?

a. b. c. d.

The firm is earning positive economic profit. The firm should shut down. The firm will suffer losses, but should continue to operate. The firm should go out of business.


300


22. Refer to the graph below. What is the value of total fixed fixed cost for this perfectly competitive competitive firm?

a. b. c. d.

$3,400 $5,800 $2,400 None of the above; there is insufficient insufficient information to answer the question.

23. Refer to the graphs below. Suppose the graph on the left represents a typical firm's supply curve in a perfectly competitive industry, industry, and there are 100 identical firms in the industry. industry. Then the graph on the right represents

a. b. c. d.

the market supply curve. the average total cost curve for the industry. the individual supply curve for each firm in the industry. the individual demand curve facing each firm in the industry.



301

24. Which term best describes the minimum amount that a firm needs to earn on a $100,000 investment to be willing to remain in a perfectly competitive industry in the long run? a. explicit cost b. opportunity cost c. economic profit d. economic loss 25. Economic loss refers to a situation in which a firm’s total revenue is less than its total cost. To calculate the amount of a loss, which of the following costs should be included? a. explicit costs only b. implicit costs only c. both explicit costs costs and implicit costs d. fixed costs only 26. Refer to the graphs below. The perfectly competitive competitive firm represented in the graph on the the right is experiencing

a. b. c. d.

a profit in the short run. a profit in the long run. a loss in the short run. a loss in the long run.


302


27. Refer to the graphs below. What do you expect to happen in this market as it approaches long-run equilibrium?

a. b. c. d.

a shift to the right of the market demand curve as new firms enter an upward shift of the firm’s demand curve as new firms enter a shift to the left of the market demand curve as new firms enter a shift to the right of the market supply curve as new firms enter

28. Refer to the graphs below. What do you expect to happen in this perfectly competitive market as it approaches long-run equilibrium?



303

a. The price will increase and profits will become zero. b. The price will decrease until it is equal to the minimum of average total cost, and profits will increase. c. The price will decrease until it is equal to the minimum of average total cost, and profits will become zero. d. Firms will exit because economic profit will become zero. 29. Refer to the graphs below. As market demand shifts to the left, how will will the firm’s level of output change?

a. b. c. d.

The firm will increase its output to increase its profits. The firm will decrease its output and suffer losses. The firm will maintain its output at the current level but suffer losses. The firm will decrease its output and earn higher profit.

30. If market demand shifts to the right, how will a competitive firm’s level of output change? a. The firm will increase its output, and its profits will increase. b. The firm will need to decrease its output and suffer losses. c. The firm will keep its output constant, but its profits will increase. d. The firm will decrease its output, which will increase its profit. 31. Long-run competitive equilibrium is a. the situation in which the entry and exit of firms have resulted in the typical firm just breaking even. b. a situation in which market price is at a level equal to the minimum point on the typical firm’s marginal cost curve. c. the end of a process during which firms are prevented from adjusting their production methods. methods. d. all of the above


304


32. Refer to the graphs below. After the market demand curve shifts to the left, which of the following would happen in this perfectly competitive market as it adjusts to long-run equilibrium?

a. b. c. d.

The market demand curve will shift back to the right. The market supply curve will shift to the right. The market supply curve will shift to the left. The market demand curve will shift further to the left.

33. If firms in a perfectly competitive industry are earning positive profits, what would you expect to see in the long run? a. The market demand curve will shift to the left as firms exit the market, prices will rise, and profits will rise. b. The market supply curve will shift to the right as firms enter the market, prices will fall, and profits will fall. c. The market supply curve will shift to the left as firms exit the market, prices will rise, and profits will rise. d. The market demand curve will shift to the right as firms enter the market, prices will rise, and profits will rise.



305

34. Refer to the graph below. Initially, the market is in long-run equilibrium at point A. If this is a constant-cost industry, after the increase in demand, through which point is the long-run supply curve most likely to cross?

a. b. c. d.

B C D none of the above

35. Refer to the graph below. Initially, the market is in long-run equilibrium at point A . Assume this is a constant-cost industry. Immediately after the decrease in demand, which point is likely to be a shortrun equilibrium and which point is likely to be the next long-run equilibrium?

a. b. c. d.

Point B is a short-run equilibrium, and point C is the new long-run equilibrium. Point D is a short-run equilibrium, and point C is the new long-run equilibrium. Point C is a short-run equilibrium, and point D is the new long-run equilibrium. Point C is a short-run equilibrium, and point A is the new long-run equilibrium.

36. What determines the position of the long-run supply curve in a perfectly competitive industry? a. market price b. the minimum point on the typical firm’s marginal cost curve c. the minimum point on the typical firm’s average total cost curve d. the minimum point on the typical firm’s average variable cost curve


306


37. Refer to the graphs below. Which graph best depicts an industry in which the typical firm’s average costs decrease as the industry expands production?

a. b. c. d.

the graph on the left the graph on the right either graph could be associated with that industry neither graph

38. Which of the following terms best describes how the result of the forces of competition drives the market price to the minimum average cost of the typical firm? a. allocative efficiency b. productive efficiency c. decreasing-cost industry d. competitive markdown 39. Which of the following terms best describes a state of the economy in which production reflects consumer preferences? a. allocative efficiency b. productive efficiency c. capitalism d. consumer equilibrium 40. When the market system allocates inputs efficiently to produce goods and services that best satisfy consumer wants, which of the following is true? a. The price of a good represents the marginal benefit consumers receive from consuming the last unit of the good sold. b. Perfectly competitive firms produce up to the point where the price of the good equals the marginal cost of producing the last unit. c. Firms produce up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it. d. all of the above



307

Short Answer Questions 1. Entry and exit ensure that perfectly competitive firms will not earn economic profits in the long run. Why would any firm remain remain in an industry if it cannot cannot earn a profit? __________________________ ______________________________________ _________________________ _________________________ _________________________ _______________ __ __________________________ ______________________________________ _________________________ _________________________ _________________________ _______________ __ __________________________ ______________________________________ _________________________ _________________________ _________________________ _______________ __ 2. Explain why the firm’s short-run supply curve is that portion of its marginal cost curve that lies above its average variable cost curve. __________________________ ______________________________________ _________________________ _________________________ _________________________ _______________ __ __________________________ ______________________________________ _________________________ _________________________ _________________________ _______________ __ __________________________ ______________________________________ _________________________ _________________________ _________________________ _______________ __ __________________________ ______________________________________ _________________________ _________________________ _________________________ _______________ __ 3. Why must perfectly competitive firms produce at the lowest point on their average total cost curves when their markets are in long-run equilibrium? __________________________ ______________________________________ _________________________ _________________________ _________________________ _______________ __ __________________________ ______________________________________ _________________________ _________________________ _________________________ _______________ __ __________________________ ______________________________________ _________________________ _________________________ _________________________ _______________ __ 4. When firms suffer short-run losses, the exit of some firms will shift the market supply curve to the left. But some firms will will remain in the the industry. Which types of of firms will leave the market? __________________________ ______________________________________ _________________________ _________________________ _________________________ _______________ __ __________________________ ______________________________________ _________________________ _________________________ _________________________ _______________ __ __________________________ ______________________________________ _________________________ _________________________ _________________________ _______________ __ 5. Explain why a perfectly competitive firm would not advertise its product in order to attract consumers away from rival firms. __________________________ ______________________________________ _________________________ _________________________ _________________________ _______________ __ __________________________ ______________________________________ _________________________ _________________________ _________________________ _______________ __ __________________________ ______________________________________ _________________________ _________________________ _________________________ _______________ __ __________________________ ______________________________________ _________________________ _________________________ _________________________ _______________ __



308

True/False Questions T T T T

F F F F

1. 2. 3. 4.

T T

F F

5. 6.

T

F

7.

T T

F F

8. 9.

T T

F F

10. 11.

T T T

F F F

12. 13. 14.

T

F

15.

Perfectly competitive firms will lower their prices in response to price cuts of rival firms. The slope of the demand curve for a perfectly competitive firm equals zero. The firm’s profit equals price minus average total cost. If a firm’s price is less than average variable cost in the short run, it will temporarily shut down. The long-run supply curve of a perfectly competitive industry is upward sloping. Allocative efficiency is achieved when a product is produced up to the point where the marginal benefit equals the marginal cost of the last unit sold. In the short run, a perfectly competitive firm will shut down if the total revenue from the quantity of output it sells is less than total cost. When perfectly competitive firms exit a market, the market supply curve shifts to the left. An increase in a firm’s fixed costs will raise its price and reduce the quantity of output it sells. When a firm’s price equals its average variable cost, it will break even. The market supply curve is derived by adding up the quantity that each firm in a perfectly competitive market is willing to supply at each possible price. The market demand curve for a perfectly competitive market is perfectly elastic. In a constant-cost industry, the market demand curve is a horizontal line. Productive efficiency is achieved when firms produce the level of output that minimizes their variable costs. Allocative efficiency is achieved when a firm produces a good or service up to the point where average total cost of the last unit produced equals price.

Answers to the Self-Test Multiple-Choice Questions Question 1

Answer d

2

a

3 4

b d

5

d

6

c

7

b

Comment Firms in a perfectly competitive market are unable to control the prices of the goods they sell, they sell identical products, and the owners are unable to earn economic profits in the long run. The three conditions that make a market perfectly competitive are: 1) There must be many buyers and many sellers, all of whom are small relative to the market; 2) The products sold by all firms in the market must be identical; and 3) There must be no barriers to new firms entering entering the market. A buyer or seller that is unable to affect the market price is a price taker. When the demand curve is horizontal, the firm can sell as much output as it wants, but it must sell the output output for the market price. If the firm increases its price, it will not sell any units of the good because consumers will choose to purchase the good from competitors who charge a lower price. To maximize profits, a perfectly competitive firm should produce that quantity of the good where the difference between the total revenue and total cost is as large as possible. In a perfectly competitive market, firms have no control over the market price and must accept the market price determined by the intersection of market demand and market supply.



8

c

9

c

10 11

c c

12

b

13

c

14

d

15

c

16

c

17

c

18

b

19 20

c b

21

c

22

c

23

a

24

b

25

c

26

a

27

d

28

c

29

b

309

For a firm in a perfectly competitive market, price is equal to both average revenue and marginal revenue. To maximize profit, the farmer should produce as long as marginal revenue is at least as great as marginal marginal cost. Marginal revenue is greater than marginal cost for bushels 4, 5, and 6, but not for output greater than 6, so the farmer maximizes profit by producing 6 bushels bushels of wheat. When total revenue is linear, marginal revenue is constant. A producer maximizes profit where marginal revenue revenue equals marginal cost. In this case, marginal revenue is greater than than marginal cost for the first 6 bushels. For the th 7 bushel and higher levels of output, the marginal cost is greater than the marginal revenue. The closest the farmer can come to equalizing equalizing marginal revenue and marginal cost is by producing 6 bushels of wheat. Profit per unit is the difference difference between price and average total cost. cost. This is the distance between points A and B on the graph. Only marginal revenue and marginal cost are needed in order to determine the level of output that maximizes profit. Profit is equal to the quantity of output produced multiplied by the difference between price and average total cost. The quantity of output produced is determined where marginal cost crosses the demand curve. Profit is maximized at the level of output where marginal revenue equals marginal cost. The firm is producing where price is equal to average total cost, so economic profit is equal to zero. Because average total cost is greater than price, the area represents losses or a negative economic profit. Average total cost is greater than price at a price of $250, and the shaded area represents the loss earned by the firm. See page 380 in the textbook. The shutdown point is the point where price is equal to the minimum of average variable cost. This occurs when the firm’s firm’s demand curve is Demand 2. When demand is Demand3, the firm can cover all of its variable costs but only part of its fixed cost. The firm earns negative economic profit, but is is better off producing than shutting shutting down. Total fixed cost is equal to the difference between total costs and total variable costs (TFC = = TC – – TVC). In this case, TC = = $58.00 × 100 = $5,800, TVC = = $34.00 × 100 = $3,400, so total fixed cost is $5,800 – $3,400 = $2,400. The market supply curve is found by adding the quantity each firm produces at a given price. A firm will remain in the industry as long as it can cover its opportunity costs of production. Economic loss is a situation in which a firm’s total revenue is less than its total cost, which includes all explicit and implicit costs. Because price is greater than average total cost, there is economic profit to be made in the short run. Because price is greater than average total cost, there are economic profits to be made and firms will enter the market. As firms enter, the market supply curve shifts to the right. As firms enter the market, the market price will decrease until it reaches the minimum of the ATC curve curve and profit will be eliminated. The lower equilibrium market price will cause the firm to reduce its output to maintain the condition where price (marginal revenue) and marginal cost are equal.


310


30

a

31

a

32

c

33

b

34

d

35

b

36

c

37

a

38

b

39

a

40

d

The higher equilibrium market price from an increase in demand would entice the profit-maximizing firm to increase its output so that price (marginal revenue) and marginal cost remain equal. The higher price will also also increase profits for the firm. In long-run competitive equilibrium, entry and exit have resulted in the typical firm just breaking even. The long-run equilibrium market price is at a level equal to the minimum point on the typical firm’s average total cost curve. Lower market demand results in losses that cause some firms to exit the industry, thereby shifting the market supply curve to the left. Positive economic profit causes some firms to enter the industry, thereby shifting the market supply curve curve to the right. The increase in supply supply reduces the market price and reduces profit. An increase in demand for apples will lead to a temporary increase in price from $10 to $15 per box, as the market demand curve shifts to the right from D1 to D2. The entry of new firms shifts the market supply curve to the right, which in the case of the constant-cost industry will cause the price to fall to its long-run level of $10. A decrease in demand will lead to a temporary decrease in price from $10 to $7 per box, as the market demand curve shifts to the left from D1 to D2. The exit exit of firms shifts the market supply curve to the left from S 1 to S 2, which causes the price to rise to its long-run level of $10. The position of the long-run supply curve is determined by the minimum point on the typical firm’s average total total cost curve. Anything that raises raises or lowers the costs of the typical firm in the long run will cause the long-run supply curve to rotate up or down. In the long run, competition will force the price of the product to fall to the level of the new lower average cost of the typical firm. In this case, the long-run supply curve will slope downward. Industries with downward-sloping long-run supply curves are called decreasing-cost industries. Productive efficiency refers to the situation in which a good or service is produced at the lowest possible cost. As we have seen, perfect competition results in productive efficiency. Allocative efficiency is a state of the economy in which production reflects consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it. When the market system allocates inputs efficiently to produce goods and services that best satisfy consumer wants: 1) the price of a good represents the marginal benefit consumers receive from consuming the last unit of the good sold; 2) perfectly competitive firms produce up to the point where the price of the good equals the marginal cost of producing the last unit; and 3) firms produce up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it.

Short Answer Responses 1. Remember that zero economic profit is not the same as zero accounting profit. The return that a perfectly competitive firm earns in the long run is equal to the value of the owner’s opportunity cost. An economic profit is a return greater than this. In competitive markets, economic profits are possible only in the short run.



311

2. A supply curve shows the relationship between the price of a product and the quantity of the product supplied. The firm’s marginal cost curve traces out the quantity the firm will supply at various prices. But for prices less than average variable cost, the firm will shut down temporarily and produce zero units of output. If price falls below average variable cost, the firm is not making enough revenue to cover all of its variables or any of its fixed costs. 3. Because the demand curve for a perfectly competitive firm is horizontal, it has a zero slope. In longrun equilibrium, the firm will will earn zero economic profit. For this to be true, price must equal average total cost. This can happen only when the demand curve is tangent to the firm’s long-run average total cost curve, and this tangency can only be where both the demand curve and the average total cost curve have slopes equal to zero. 4. Owners of firms are in different locations and have different opportunity costs. Some will be more optimistic about the future of their markets than others. Owners who are less optimistic about the future prospects for profit are more likely to leave. Some firms are also likely to have greater financial resources than others. The firms with lower financial resources are more likely to leave the market when they experience losses. 5. Successful advertising allows firms to gain sales at the expense of other firms and/or to raise the prices of the products they advertise. In perfectly competitive markets, firms can sell all the output they wish to sell at the market price. Advertising would only add to cost and reduce profits.

True/False Answers 1.

F

2. 3. 4. 5.

T F T F

6. 7. 8. 9.

T F T F

10.

F

11. 12. 13. 14.

T F F F

15.

F

Perfectly competitive firms are price takers and will charge the same price other firms in that industry are charging. The slope of the demand curve—the change in price divided by the change in quantity—is zero. This defines profit per unit, not total profit. Because P < < AVC , the firm cannot cover all the losses. The statement describes an increasing-cost industry. A perfectly competitive market can have constant, increasing, or decreasing long-run costs. See the definition of allocative efficiency on page 391 in the textbook. The firm will continue to produce if total revenue exceeds total variable costs. A decrease in the number of firms in the market will cause the market supply curve to shift left. Changes in fixed costs will affect a firm’s profit but not its output because this does not affect marginal cost. Changes in price result result from changes in market demand and supply. supply. Breaking even occurs when all costs are covered and there is no additional revenue left over, that is, when P = = minimum of the ATC curve. curve. See Figure 11-7 on page 382 in the textbook. The firm’s, not the market’s, demand curve is perfectly elastic. In a constant-cost industry, the long-run market supply curve is a horizontal line. Productive efficiency occurs when a firm produces the quantity that minimizes average total cost. Allocative efficiency is achieved when a firm produces up to the point where the marginal benefit of the last unit equals equals the marginal cost of producing producing it.


Firms in competitve market(Microeconomics)

Recommend Documents